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June 5, 2013

SEC Floats Two-Pronged Money Fund Reform Plan

A floating NAV for institutional prime funds as well as fees and gates ‘could be adopted separately or combined,’ says SEC Chief White

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The Securities and Exchange Commission on Wednesday proposed two alternative reforms to money-market funds.

First, to require that all institutional prime money-market funds operate with a floating net asset value (NAV). Second, to employ a "fees-and-gates" approach in which a nongovernment money fund imposes a 2% liquidity fee if the fund’s weekly liquid assets fall below 15% of its total assets.

SEC Chairwoman Mary Jo White said that the two reforms could be adopted separately or combined into a single reform package. “The two alternative approaches in today’s proposal target the common goal of reducing the incentive to redeem in times of stress, albeit in different ways,” White said.

Since the financial crisis of 2008 highlighted the susceptibility of money-market funds to runs, White said in her remarks that the commission staff has spent “literally years studying different reform alternatives and performing extensive economic analysis in arriving at these recommendations.”

These proposals, she said, “are important in and of themselves and because they advance the public debate that will shape the final rules to address one of the most prominent events arising from the financial crisis.”

As White explained, the floating NAV proposal specifically targets the funds where the problems during the financial crisis occurred: institutional, prime money-market funds.

While the proposal exempts retail and government money funds from a floating NAV, White said that the SEC wants to hear from commenters not only on the impact of targeting the floating NAV reform to institutional prime funds, but also on whether government and retail funds should operate with a floating NAV, and whether the proposal would effectively differentiate retail funds from institutional funds by imposing a $1 million redemption limit.

Jack Murphy of the law firm Dechert noted that the SEC proposal to define retail funds by reference to whether or not a fund has placed a $1 million limit on redemptions “is an interesting way to go about trying to distinguish between retail and institutional funds.” Of course, he said, “the devil will be in the details, as many funds have their shares held in street-name accounts by intermediaries, which could complicate the process of making sure that the limit is adhered to.”

White said the floating NAV reform proposal was important for three reasons:

First, by eliminating the ability of early redeemers to receive $1 a share—even when the fund has experienced a loss and its shares are worth somewhat less—this proposal should reduce incentives for shareholders to redeem from institutional prime money-market funds in times of stress;

Third, the proposal is targeted, by focusing reform on the segment of the market that experienced the run in the financial crisis.

Murphy of Dechert noted that the floating NAV, which requires that prices be rounded to the nearest basis point, “would be much more stringent than the standard to which other non-money-market funds historically have been held.” In addition to possible operational issues that would have to be addressed, he said, “it does seem a bit incongruous that money-market funds, which are safer than other types of funds, would be held to higher standard of care than other funds.”

Under this alternative, nongovernment money funds would be required to impose a 2% liquidity fee if the fund’s level of weekly liquid assets fell below 15% of its total assets, unless the fund’s board determined that it was not in the best interest of the fund.

That determination would be subject to the board’s fiduciary duty, White said, “and we believe it would be a high hurdle. After falling below the 15% weekly liquid assets threshold, the fund’s board would also be able to temporarily suspend redemptions in the fund for up to 30 days—or ‘gate’ the fund.”

White said the fees-and-gates approach has the potential to enhance current money fund rules by:

more equitably allocating liquidity risk by assigning liquidity costs in times of stress (when liquidity is expensive) to redeeming shareholders—the ones who create the liquidity costs and disruption;

providing new tools to allow funds to better manage redemptions in times of stress, and thereby potentially prevent harmful contagion effects on investors, other funds and the broader markets. If the beginning of a run or significantly heightened redemptions occur, they would no longer continue unchecked, potentially spiraling into a crisis. The imposition of liquidity fees or gates would be an available tool to directly counteract a run; and

Targeting, focusing the potential limitations on a money-market fund investor’s experience to times of stress when unfettered liquidity can have real costs.

White also pointed out that the proposal contains a number of other significant changes—tightening diversification requirements, enhancing disclosure requirements, strengthening stress testing and improving reporting on both money-market funds and unregistered liquidity funds that could serve as alternatives to money-market funds for some investors.

The Investment Company Institute released a statement Wednesday noting that it appreciated the “extensive research” the SEC has undertaken on money-market fund reforms, and that the SEC “has the regulatory expertise to address the vital issues involved.”

ICI said that it is “particularly pleased that the commission recognized the effectiveness of liquidity fees and gates in addressing risks that might arise in a widespread crisis. We also welcome the inclusion of fees and gates as a standalone option in the proposal.”